March 22, 2009

The Geithner Plan: Take 1

by hilzoy

Some negative reactions to the Geithner plan: Krugman, more Krugman, Calculated Risk, Yves Smith, James K. Galbraith, Henry Blodget, Noam Scheiber. Brad DeLong, on the other hand, likes it, and whether you agree with him or not, he's made the strongest case I can think of for it, and it's absolutely worth reading, as is Krugman's response. All of these people actually know what they're talking about. I, on the other hand, do not: I'm just a reasonably informed non-economist like, I assume, most of you. Take what follows in that light, and if your time is short and you have to choose between reading me and reading, say, Krugman or DeLong, choose the latter. Also, if I get anything wrong, please let me know.

That said, several problems with this plan, and specifically with Geithner's proposal to create public/private partnerships which will bid against one another to buy various toxic assets, just leap out at me. For one thing, it might not work at all. From the NYT:

"Risk-taking institutional investors, like hedge funds and private equity funds, have refused to pay more than about 30 cents on the dollar for many bundles of mortgages, even if most of the borrowers are still current. But banks holding those mortgages, not wanting to book huge losses on their holdings, have often refused to sell for less than 60 cents on the dollar."

How, one might wonder, will holding an auction help here? If the banks are not willing to sell below 60 cents on the dollar, then absent nationalization or something similarly drastic, we can't force them to. If potential buyers are not willing to pay the price banks insist on, then the auction will simply fail, the assets will remain on the banks' books, and nothing will have been accomplished. And if the NYT is right about the gap between the price at which banks are willing to sell and what buyers are willing to pay, then the only way for an auction to work is if it somehow persuades one group to change its mind.

As it happens, some of the auctions Geithner plans to propose will do just that. From the WSJ:

"To target troubled securities, such as mortgage-backed securities, the government will create several investment funds. Treasury will act as a co-investor, in most cases contributing $1 for every $1 contributed by the private sector and sharing in the first-loss position.

To target troubled loans, the government will create a Disposition Finance Program with the FDIC. In that case, the government will be a co-investor, but could also agree in some cases to contribute 80% of the financing, with the government putting up $4 for every $1 in private financing. As part of that program, the FDIC would provide guarantees against losses on a pool of loans that a bank wants to sell. The program could guarantee as much as $500 billion in loan investments."

In the first sort of auction, we share the risk with private investors. In the second, however, we assume it all. Obviously, buyers will be willing to pay more for otherwise risky assets if the government guarantees any losses they might suffer. Why? Because any investment is worth more if you don't have to worry about losing money. As Ezra says:

"A private auction will not price the assets. It will price the potential upside of the assets given that taxpayers will assume the brunt of the losses. As illustration, imagine an art auction. Now imagine an art auction where Sotheby's loans money to the participants and promises to pay the losses if the paintings fall in value. Think the pricing will be the same?"

This means several things. First, one of the things you might think that an auction would do would be to help us to figure out what these assets are really worth. But while the auctions of troubled securities might do that, the auctions of troubled loans will not. They will, at best, help us to figure out what those loans would be worth if they had no downside risk. That's a different thing entirely. And it means that this auction will be useless for figuring out what those loans are actually worth.

Second, buyers will presumably pay more for these loans than they would have done had they had to assume their risks along with their potential gains. This might help overcome the gap between what buyers are willing to pay and what sellers are willing to accept. But it does so by artificially inflating the price of risky loans. Since we, along with the private investors, will be paying these artificially inflated prices, this is a subsidy to the banks, and should be recognized as such.

Third, it's worth reemphasizing this point: we, the taxpayers, assume a lot of the risks under this plan. This is one reason why, as Paul Krugman says, it's a huge gamble on the proposition that the assets in question are undervalued, and will regain their value as soon as the economy returns to normal. If that's true, then we will probably get our money back, though we won't do as well as we would have done had we paid market prices. But if it's not, then we will be left holding the bag. And it's a very, very big bag.

I would like to point out one extra point that Yves Smith keeps mentioning...by including "private capital" it makes the program less efficient and makes the bag we're holding even larger because the private capital has to make money in order to be in on it. It's not just a subsidy to the banks, it's a transferral of wealth to large asset management funds.

The numbers she throws around from some commenters suggest that it will lead to 20-30% larger losses than if we had just guaranteed all the debt (which I think is far to large to guarantee it all in the first place) right now. And that is just based on what a rational, honest actor would do. Other commenters have pointed out all the potential for fraud.

In sort, this is by far the worst plan since proposed.

Also, Yves Smith, Calculated Risk, Henry Blodget and to a large extent Paul Krugman saw this crisis coming long before it did, in the exact way it did. (Krugman gets props for seeing the fundamental imbalances but for having too much faith in traditional economics to fight against it.)

Brad DeLong had tons of commentary explaining why there was no need to worry. At one point he said that there was no such thing as overcapacity because the government could just increase subsidies until it was met, so he didn't see how housing could go bust so much because they could do that.

Needless to say, for my money the universal dismissal of the people that have a good grasp on the situation far outweighs DeLong's defense.

"Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition."

Um, we had the largest bubble in the history of the planet. Simply going back to historical valuation and then rising at historical rates (housing tracks inflation perfectly, so if assuming a 2% inflation rate) would STILL see housing not get back to normal price values...and that's not even including all the hits from defaults that are going to occur.

That is fear mongering, plain and simple. The most realistic way that "bottled water, sewing needles, and ammunition" will be the only thing of value is if the government continues to try to bail out everything and causes a hyperinflationary spiral...not if they take over the banks and force writedowns!

Which is the Krugman response in a way.

I'm sure DeLong's defense is the best one that can be given, and it's literally saying it's OK that we transfer mass amounts of money to these private backs that will "make a fortune if things recover" and we'll take massive losses if we don't. The plan is so astronomically bad that it should convince anyone that has supported Geithner to jump on the resignation bandwagon.

"Risk-taking institutional investors, like hedge funds and private equity funds, have refused to pay more than about 30 cents on the dollar for many bundles of mortgages, even if most of the borrowers are still current. But banks holding those mortgages, not wanting to book huge losses on their holdings, have often refused to sell for less than 60 cents on the dollar."

An additional data point to consider is that per CalcRisk it appears there are some circumstances such that banks are willing to take less than 60 cents on the dollar (i.e. vs. peak bubble pricing), and this is when they have direct ownership of the title to foreclosed homes, which they don't have the staffing to manage, and thus are dumping them at below market rates as REO sales.

This suggests to me that the banks have good reason not to value their more complex mortgage backed securities as highly as they would like us to believe. The conclusion I draw is that Geithner's plan is bank recapitalization in disguise - a way of putting lipstick on the mortgage pig. And a bonnet. And pantaloons...

Porcine singing lessons (pace Heinlein) are yet to be scheduled but probably lurking somewhere in the future.

Now I'm not convinced that the alternatives of either (1) simply letting the major banks fail, or (2) nationalizing them and then putting them thru a triage process, are going to be any better at this point in time. We may have no choice but to recapitalize the banks with taxpayer money, at least until their balance sheets are healthier than at present, at which point the other failure/triage options may become more realistic*.

But if we are going to do that (recapitalization) I'd much rather it be openly and honestly debated so we all understand what is at stake and what policy choices are being made and why. This plan does not accomplish that - it strikes me as a Rube Goldberg machine designed to accomplish recapitalization in as complex a fashion as possible so as to disguise what is really going on.

Also, if we have to recapitalize the banks, I don't see any way to do that which is congruent with any sense of economic and social justice. No matter how we twist and turn, there just isn't going to be any way to do this without rewarding failure and enriching folks who are either already very wealthy or responsible for this disaster, or both. I think that is just part of the price of past policy mistakes and crimes which we have no choice but to squarely face now - there is no magic spell that can undo what has been done. In our folly the Pied Piper was hired to deal with our rodent problem, and now it is time to pay up, or else.

Thus I think we need to look to criminal prosecutions where existing laws have been broken, and to other policy options (such as steeper progressive taxation) to restore a sense of social and economic justice which will inevitably be profoundly ruptured by any feasible plan for bank recapitalization.

IMHO it is going to be difficult if not impossible to come up with a purely technocratic plan to rescue the global economy from a very deep depression. Trying to do so in a manner which is broadly understood to be fair as well as being effective is asking for miracles. We need to understand this and find other ways to restore a sense of fairness and balance to our society.

*There is another reason why IMHO bank failure/triage may not be on the table right now - the interconnectedness of the financial system. I think we need time to carefully dismantle the systemic connections which tie the various banks and other firms to each other. That is going to take both very extensive new regulations and an unwinding of things like the CDS. Neither of which can be done in a rush.

Metaphorically, I'd say our existing financial system is like a set of Conjoined twins (octuplets is more like it, but you get the idea) who are in the ICU after a very severe accident (a self-inflicted one in this case). First we have to stabilize the patient(s), then perform extensive microsurgery to separate the individuals. Only then can we start making end of life decisions for some of them. Right now we are still in the first stage, using massive blood transfusions to get the patient(s) recovered to a point where surgery is feasible.

why would we be better off simply buying the asset entirely ourselves, under the assumption that you are better off having both risk and reward, rather than merely risk?

I think the problem with us simply buying the assets directly is that the process of "buying" them is in fact an enormous and administratively very complex task requiring an huge staff to execute, especially if we want to do it in a short period of time. This means we need a great deal more trained people to do this than Treasury currently has on staff. The unpleasant reality is that the overwhelming majority of the people who are currently trained to execute these sort of transactions work in the private sector - the staffing at Treasury and the Federal Reserve and the FDIC is miniscule in comparison with the size of the firms on Wall St. Our public agencies just don't have the staffing required to run even just the US FIRE sector economy in a central planning fashion, much less to figure out the global picture.

So if we have to hire somebody to do it for us, we better make sure that their incentives are aligned with ours. The Geithner plan is structured to attempt to do that.

"There is another reason why IMHO bank failure/triage may not be on the table right now - the interconnectedness of the financial system. I think we need time to carefully dismantle the systemic connections which tie the various banks and other firms to each other."

I agree completely, but there is no way in hell that the banks are going to cooperate with this. To me the best plan is nationalization in order to force open the books, evaluate the quality of assets and have a very open and honest policy of how losses are going to be distributed.

From my mathematical point of view (and you probably agree since you seem rather systems oriented) by adding a bunch of external forcing into the system, it's causing massive volatility as capital (and expectations) are sloshing around markets, which is destroying the ability to properly evaluate assets and leading to worse problems. I'd much rather have governments take over the financial system and break it apart into more analyzable pieces than just flood it with trillions in liquidity.

To me the best plan is nationalization in order to force open the books, evaluate the quality of assets and have a very open and honest policy of how losses are going to be distributed.

Ditto that, but I think that at the present time we do not have the staffing levels in our public agencies to do this. A lot of the nationalization plans that I'm reading folks call for simply assume that there are tens or even hundreds of thousands of trained employees at Treasury / Fed / FDIC simply sitting around doing nothing but standing by waiting for the call to action, who can then step in immediately and start doing this. Either that, or they aren't thinking at all about what nationalization means in detail, in terms of the purely administrative mechanics. But right now Treasury is no more prepared to nationalize the banks than was the US Army prepared to hit the battlefields of the western front in mid-1917. You can't fight with an army that you don't have yet.

But if we are going to do that (recapitalization) I'd much rather it be openly and honestly debated so we all understand what is at stake and what policy choices are being made and why.

I absolutely agree with this, but I'm not sure it's on the table. Congress hasn't shown much ability to have a quality, open, honest debate about these things lately. Remember that anything proposed will have to get through a filibuster. If such a debate doesn't happen there, then we won't be able to move forward.

Now I'm not convinced that the alternatives of either (1) simply letting the major banks fail, or (2) nationalizing them and then putting them thru a triage process, are going to be any better at this point in time.

I've had to lurk for most of the past six months -- Real Work is too damn time consuming -- but this is something I'm not quite getting. Why is it that you feel that nationalization + triage is not a better choice right now? I agree that this is backdoor recapitalization -- and not even particularly backdoor -- which, to me, seems to ultimately devolve to all the downsides of nationalization without any of their upsides. What's gained by not nationalizing now?

Why is it that you feel that nationalization + triage is not a better choice right now?

A very good question.

I'm of the opinion that nationalization + triage scenarios assume that the links which connect the various banks and other firms (not just within the US but also internationally) can be cleanly severed within a short period of time. I think the fallout from the Bear Stearns and Lehman failures suggests the opposite, especially when you consider that two of the at-risk US firms most likely to be targets of nationalization in the near future (AIG and Citi) are much more tightly integrated with the rest of the financial system than was Lehman and much, much larger than BS was.

So what would happen if a nationalized firm cannot be quickly and cleanly severed from its brethren? I think this would have the potential to trigger a general systemic failure - the biggest danger would be a run on deposits. If a depository bank or money market fund with large counter-party relationships to the nationalized firm looked like it was going to fail as a result of the nationalization, then govt.'s will have to scramble to compartmentalize that. I don't think they have the tools in place to do this yet (e.g. look at the depleted state of the FDIC reserve fund right now).

So my worry is that there are too many banks with too high of a leverage ratio right now, making it more likely that an Iceland scenario will break out somewhere. Once it starts, can we contain it, or does it go global? There can be network effects - for example if in response to a run on one of its banks govt. X suddenly announces that it is backing all deposits with unlimited guarantees, that could trigger an outflow of deposits from other nations lacking the same level of guarantee (as happened last fall with Ireland and the EU) which would have the peverse effect of spreading the crisis more widely rather than compartmentalizing it.

I think this danger will recede in proportion to banks getting their leverage ratios down, but that takes time and money. Also, I think that our regulatory agencies (not just in the US but in Europe) are operating at a considerable disadvantage in both staffing and information, relative to the task we are asking of them – they don’t have enough people and they need to take inventory of the existing counterparty relationships between the banks (one of the frightening thing about the CDS is that they were/are nearly invisible to regulators). They also need to work out what steps will be taken in terms of cross-border cooperation to deal with the fallout that might occur from a major nationalization. If Treasury, the Federal Reserve, the FDIC, the ECB, the PBoC, the BoJ and other major actors aren't on the same page regarding what steps to take given various scenarios in the wake of a major nationalization, we could lose control of the situation very quickly.

So I think that we have a lot of work to do both domestically and internationally to prepare ourselves, and backfilling the holes in banks balance sheets may be the best course of action until that work has been done and we have better systemic safety nets in place.

"But right now Treasury is no more prepared to nationalize the banks than was the US Army prepared to hit the battlefields of the western front in mid-1917. You can't fight with an army that you don't have yet."

One would think the existing banks would be able to administer loan/ mortgage portfolios. [Please don't break into hysterical laughter]. Could they be hired on a cost plus basis to do the administration? I wouldn't pay them the plus, but apply it against their TARP liability.

So what would happen if a nationalized firm cannot be quickly and cleanly severed from its brethren? I think this would have the potential to trigger a general systemic failure - the biggest danger would be a run on deposits. If a depository bank or money market fund with large counter-party relationships to the nationalized firm looked like it was going to fail as a result of the nationalization, then govt.'s will have to scramble to compartmentalize that.

just so nobody freaks out, i think it's worth pointing out that money market checking accounts at FDIC-insured banks (where the value of the account is within the FDIC limits) is still insured by the FDIC. however a money market mutual fund which you might have at a brokerage, will not be insured.

well, it's also a way to try to placate those people who are deathly afraid of the dread socialism.

look, i'm not trying to defend Geithner's plan (which i happily admit is well outside my domain), but i find it hard to believe that Obama and everybody else in his administration is as stupid as everybody says Geithner must be. nothing about what we've seen from Obama says "ignorant", or "short-sighted", or "blinkered" or "Wall St shill" or any of the other things he must be if he thinks this plan is anything but the best plan available at the moment. and accepting that Obama is not dumb, nor blind, nor ignorant, for him to green-light this plan, while all of you disagree on first sight, suggests to me that he's looking at a different set of facts than you are.

Why I don't have faith in Geithner - or the notion that there is some behind the scenes set of facts that we are not privy to, but which militate in favor of his plan.

So, know, I don't think I know all the facts. What I'm saying is, if there are facts which militate in favor of his plan but that are not yet publicly known, he is giving zero indication, and is instead relying on shallow, inaccurate rhetoric and other feints and dodges.

"Legacy loans" and the like.

Obama is, and has always been, a moderate, cautious politician (in the Senate, in his campaign, and in his early admin days). That to me suggests that he could be heeding advice from people like Geithner and Summers out of fear of acting too drastically.

Also: Obama is not immune to the extreme lobbying power of Wall St. - and all those groups that could get burned via receivership. Any and all politicians are subject to those influences. Obama too. Much as it pains me.

Trust Obama? Sure. A trillion dollars worth? Nope. The last politician who said "Trust me" on something this big was Bush on Iraq. That worked really well. If this plan doesn't work it's bye-bye to universal health care, infrastructure, everything. You can't really count on being able to piss away $1 trillion dollars more than once. And don't forget Bernanke is in there burning thru trillions all by himself. Obama's betting the ranch on Geithner, and that makes some of us nervous.

Obama's not stupid, but he's a successful politician. That means he's had to be an egoist just to get where he is.

So, know, I don't think I know all the facts. What I'm saying is, if there are facts which militate in favor of his plan but that are not yet publicly known, he is giving zero indication, and is instead relying on shallow, inaccurate rhetoric and other feints and dodges.

again, i think the fact that his plan seems at odds with what all the outsiders good economic sense (along with the assumption that Obama is not an idiot) is clear evidence that they're working from a different set of facts (and assumptions) than everyone else.

yes, he can still be wrong.

Obama is, and has always been, a moderate, cautious politician (in the Senate, in his campaign, and in his early admin days). That to me suggests that he could be heeding advice from people like Geithner and Summers out of fear of acting too drastically.

yes, perhaps.

But his plan is not receiving criticism for being socialistic.

google the magic words. it's not too tough to find people who think his bailout plan is socialism.

again, i think the fact that his plan seems at odds with what all the outsiders good economic sense (along with the assumption that Obama is not an idiot) is clear evidence that they're working from a different set of facts (and assumptions) than everyone else.

Assumptions, perhaps. That's clear. That doesn't mean their approach is better. Just that they've made up their mind that they're not going to do what Sweden does becuase this is the United States of America. And that they fully intend on implementing the Paulson/Bush plan that Paulson/Bush backed off of.

google the magic words. it's not too tough to find people who think his bailout plan is socialism.

Not from any serious sources. And, importantly, it's not socialistic or even reminiscent of socialism. Nationalization would be - at least - on its face and in its terminology.

Not from any serious sources. And, importantly, it's not socialistic or even reminiscent of socialism.

sure. anyone who is screaming "socialism!" about Obama isn't serious. but when has that stopped em from screaming it?

Assumptions, perhaps.

i'm really not sure why you keep seeming to deny that they don't know more about the situation than we do. how could they not ?

That doesn't mean their approach is better.

agreed. and i'm trying hard to avoid saying it is or it isn't. i honestly don't know and wouldn't dare offer an opinion.

Just that they've made up their mind that they're not going to do what Sweden does becuase this is the United States of America.

well, *shrug*, it isn't. and that fact counts for something, when it comes to huge global investment banks, insurance companies and the people who want to use such things. they're probably trying to protect the American "brand", too.

i'm really not sure why you keep seeming to deny that they don't know more about the situation than we do. how could they not ?

I'm denying that what they know somehow makes their approach make sense.

agreed. and i'm trying hard to avoid saying it is or it isn't. i honestly don't know and wouldn't dare offer an opinion.

I'm not one for blind faith. If there are facts that make their plan make sense, they need to share those with the American people. This reminds me of arguments people made to me back in 2002: Bush knows something about Iraq he's not telling us. If you knew what he knew, you'd support the invasion too Eric.

Now, I'm not comparing Obama to Bush, just saying that I'm not checking my critical thinking at the door in favor of faith.

Removing devalued loans and securities from banks’ balance sheets is a short-term solution that will delay the problem’s ultimate solution, which is bank takeovers, Bernstein said. The government won’t be able to inflate the prices banks receive for selling bad assets indefinitely, he added.

This reminds me of arguments people made to me back in 2002: Bush knows something about Iraq he's not telling us. If you knew what he knew, you'd support the invasion too Eric.

oh yes. without question.

but i used the following line here a few days back in response to a similar comparison:

Bush 2002 or Bush 2007 ?

the point being, in 2002 we didn't know that Bush was misleading us - at least we didn't know it immediately. it took a few months for enough evidence to build up. and even then, only a few people recognized it - and most so-called "foreign policy experts" were on Bush's side. for years. i don't think we're there with Obama yet. other people may. YMMV, etc..

sure, maybe it's blind faith on my part.

Presumably, they have a decent understanding of at least a couple of institutions involved

yep.

The government won’t be able to inflate the prices banks receive for selling bad assets indefinitely

and those banks which are really in bad shape and can't hold out will nationalized/go through bankruptcy - just as they already are. Atrios lists a half-dozen every week.

I don't have any more insight than anyone else about whether this is a deliberate part of Geithner's plan. Oddly enough, though, his tongue-tied interviews about it make me suspect that it might be. Geithner might not be the most silver-tongued spokesman in the Obama orbit, but he's not a doofus. If he's having trouble explaining the plan in public, one reason might be that he's unable to fess up to the central pillar of the whole thing: forcing banks to put up or shut up.

Somebody is wrong about all this stuff, after all. Either the critics are wrong, and banks are actually perfectly solvent, or else the banks are wrong, and all their memos about how they're practically sagging under the weight of all their Tier 1 capital are just a bunch of hooey. Geithner's plan goes at least part of the way to figuring this out.